Deze samenvatting is geschreven in collegejaar 2012-2013.

Chapter 1 Economics: Foundation and Models

Basic fact of life: People must make choices to attain their goals because we live in a world of scarcity.

Scarcity

A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Economics

The study of choices people make to attain their goals, given their scarce resources

Economic model

A simplified version of reality used to analyze real-world economic situations.

1.1 Three Key Economic Ideas

1. People are rational.

• Rational individuals weigh the benefits and costs of each action, and choose an action only if benefits outweigh costs

2. People respond to economic incentives.

• Consumers and firms consistently respond to the less costly alternative

3. Optimal decisions are made at the margin.

• Marginal (cursive) means 'extra' or 'additional'

• Economist reason that optimal decision is to continue any activity up to the point where marginal benefit (MB) equals marginal costs (MC). MB=MC

• Marginal analysis: Analysis that involves comparing marginal benefits and marginal costs

1.2 The Economic Problem That Every Society Must Solve

Since we live in a world of scarcity with only a limited amount of resources, every society faces trade-offs, that are measured by opportunity costs.

Trade-off

The idea that because of scarcity, producing more of one good or service means producing less of another good or service

Opportunity cost

The highest-valued alternative that must be given up to engage in an activity

Trade-offs force society to make choices when answering the following three fundamental questions:

1. What good and services will be produced?

• The answer is determined by consumers, firms and the government

2. How will the goods and services be produced?

• Usually firms face a trade-off between using more workers or using more machines

3. Who will receive the goods and services produced?

• The answer depends largely on how income is distributed

Centrally planned economy

An economy in which the government decides how economic resources will be allocated. The government decides what goods to be prodeced ,how the goods would be produced ,and who would receive the goods.Government employees manage factories and stores.Centrally planned economies,such as the Soviet Union have not been successful in producing low-cost,high-quality goods and services.As a result,the standard of living of the average person in the centrally planned economy tends to be low.Nowadays only a few small countries,such as Cuba and North Korea,still have completely centrally planned economies.

Market economy

Market econom is one in which the decisions of households and firms interacting in markets allocate economic resources.All the high income democracies,such as United States,Canada,Japan are market economies.In a market economy the income of an individual is determined by the payments he receives for what he has to sell.The most attractive feature of market econmies is that they reward hard work:generally the more extensive the training the person has received and the longer the hours the person works-the higher the person;s income will be.

Mixed economy

An economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources. The majority of the market economies in the world are in practice mixed economies,thus United States,Japan etc…are mixed economies.

Market economies tend to be more efficient than centrally planned economies because they promote competition and facilitate voluntary exchange. There are two types of efficiency:

Productive efficiency

A situation in which a good or service is produced at the lowest possible cost

Allocative efficiency

A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.Markets tend to be efficient because they promote competition and facilitate voluntary exchange.

Voluntary exchange

A situation that occurs in markets when both the buyers and sellers of a product are better off by the transaction

An economically efficient outcome is not necessarily a desirable one. Many people prefer economic outcomes that they consider fair or equitable, even if those outcomes are less efficient. There is often a trade-off between efficiency and equity.

Equity

Equity is harder to define than efficiency,but it usually involves fair distribution of economic benefits

1.3 Economic Models

Economic models are simplified versions of reality.One purpose of economic models is to make economis ideas sufficiently explicit and concrete so that individuals,firms or the government can use them to make decisions.

To develop a model economists generally follow these steps:

1. Decide on the assumptions to use in developing the model -> Reduce complexity of issue

2. Formulate a testable hypothesis

• Hypothesis: Statement that may be either correct or incorrect about an economic variable

• Economic variable: Something measurable that can have different values, such as the wages of software programmers

3. Use economic data to test hypothesis

4. Revise model if it fails to explain the economic data

5. Retain the revised model to help answer similar economic questions in the future

If we build economic models we have to distinguish clearly between two analyses:

Positive analysis

Analysis concerned with what is

Normative analysis

Analysis concerned with what ought to be

Economics is about positive analysis ,which measure the costs and benefits of different courses of action.

Economic is considered to be a social science, since it examines the human behavior in every context, not just in the context of business.

1.4 Microeconomics and Macroeconomics

Microeconomics

The study of how households and firms make choices, how they interact in markets, and how government attempts to influence their choices.Microeconomis issue include explaining how consumers react to changes in product prices and how firms decide what prices to charge for the products they sell.Microeconomics also involves policy issues.

Macroeconomics

The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.Macroeconomics issue include explaining why economies experience periods of recession and increasing unemployment and why,over the long run,some economies have grown much faster than others.The policy issue that macroeconomics involves is that whether government intervention can reduce the severity of recession.

The line between microeconomics and macroeconomics is very fine. Many economic situations consider both aspects.

1.5 A Preview of Important Economic Terms

Entrepreneur - Someone who starts and operates a business and decide what goods and services to produce and how to produce them.An entepreneur starting a new business puts his or her own money at risk.Without entepreneurs willing to assume the risk of starting and operating a business,economic progress would be impossible in a market system.

Innovation –A distinction between invention and innovation must be made.An invention is the development of a new good or a new process for making a good.An innovation is the practical application of an invention or a significant improvement in a good or in the means of producing a good

Technology - Processes a firm uses to produce goods and services.In economic sense,a firm’s technology depends on many factors suchasthe skills of its managers,the training of its workers,and the speed and efficiency of its machinery and equipment.

Firm, company or business - Organization that produces a good or service.

Economists use these 3 terms interchangeably.

Goods - Tangible merchandise, such as books or computers

Services - Activities done for others, such as providing haircut or investment advice

Revenue - Total amount received for selling a good or a service. Calculated my multiplying price per unit by number of units sold

Profit – The difference betwwen firm’s revnue and costs.

Accounting profit - Exclude cost of some economic resources that the firm does not pay for explicitly

Economic profit - Include opportunity costs of all resources used by the firm

Household - All persons occupying a home. Households are suppliers of factors of production - particularly labor- used by firm to make goods and services

Factors of production or economic resources - Used by firms to produce goods or services Main factors are: labor, capital, natural resources and entrepreneurial ability

Financial capital - Stocks and bonds issued by firms, bank accounts, and holdings of money

Physical capital - Manufactured goods that are used to produce other goods and services.Examples of physical capital are computers,factory buildings,machne tools,warehouses,and trucks.

Human capital - Accumulated training and skills that workers possess

Chapter 2 Trade-offs, Comparative Advantage, and the Market System

Scarcity is a situation in which unlimited wants exceed the limited resources available to fullfil those wants.Scarcity requires trade-offs.Goods and sevices are scarce,so too are the economic resources,or facotrs of production-workers,capital,natural resources, and entrepreneural ability-used to make goods and services.

Due to the concept of scarcity the households and firms need to make decisions.They make many of their decisions in markets.Trade is a key activity that takes place in markets.By engaging in trade people car rise their standard of living.

In order to make an analysis of the economic consequences of scarcity and the working of the market system we shall introduce an important economic model: The production possibilities frontiers.

2.1 Production Possibilities Frontiers and Opportunity Costs

Production possibilities frontier (PPF)

A curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology. We can use production possibility frontier to explore issues concerning the economy as a whole.

Combinations on the frontier are efficient because all available resources are being fully utilized,and the fewest possible resources are being used to produse a given amount of output.

Combinations inside the frontier re inefficient because maximum output in not being optaint from the available resouces.

Combinations beyond the production possibilities frontier are unattainable,given the firm’s current resouces.

Notice that when a firm is producing efficiently and is on the production possibilities frontier the only way to produce more of one ood is to produce less from another.

Opportunity cost

The highest-valued alternative that must be given up to engage in an activity

Increasing marginal opportunity cost

As economy moves down the production frontier, it experiences increasing marginal opportunity costs because increasing a product A's production by a given quantity requires larger and larger decreases in a product B's production. The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.The idea of increasing marginal opportunity costs illustrates an important economic concept:The more resouces already devoted to an activity,the smaller the payoff to devoting additional resources to that activity.

Economic growth

Shifts in the production possibilities frontier represent economic growth because they allow economy to increase the production of goods and services, which ultimately raises the standard of living.Over time the resources available to an economy may increase.For example,both the labor force and capital stock –the amount of the physical capital available in the country my increase.This increase shofts the production possibilities frontier outward.

Similarly,technology change makes ot possible to produce more goods with the same number of workers and the same amount of machinery,which also shifts the production possibilities frontier outward.Note that technology change need not affect all sectors equally.

2.2 Comparative Advantage and Trade

Trade

The act of buying and selling. One of the great benefits of trade is that it makes it possible for people to become better off by increasing both their production and their consumption.

Note:Tha basis for thrade is comparative advantage,not absolute advantage.

Absolute Advantage

The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources

Comparative advantage

The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors

There are two key points to keep in mind when dealing with Absolute and comparative advantages:

1. It is possible to have an absolute advantage in producing a good or service without having a comparative advantage.

2. It is possible to have a comparative advantage in producing a good or service without having an absolute advantage.

2.3 The Market System

Market

A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Markets can take many forms, such as physical places e.g. New York Stock Exchange or virtual places, e.g. eBay. In a market buyers are demanders of goods and services, and the sellers are suppliers of good and services.

Households and firms interact in two types of markets:

1. Product markets

Markets for goods - such as computers - and services - such as medical treatment.In product markets,households are demanders and firms are suppliers.

2. Factor markets

Markets for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability.

Factors of production

The inputs used to make goods and services. They can be divided into four broad categories:

1. Labor - All types of work, from part-time labor to work of top managers in large corporations.

2. Capital - Refers to physical capital, such as computers and machine tools, that is used to produce other goods.

3. Natural resources - Include land, water, oil, iron ore, and other raw materials that are used in producing goods.

4. Entrepreneurial ability - The ability to bring together the other factors of production to successfully produce and sell goods and services

Two key groups participate in markets:

1. Household

All individuals in a home. Households are suppliers of factors of production - particularly labor - employed by firms to make goods and services. Households use income they receive from selling factors of production to purchase goods and services supplied by firms.

2

Spending on goods and services

Labor, capital, natural resources and entrepreneurial ability

. Firms

Suppliers of goods and services. Firms use the fund they receive from selling goods and services to buy the factors of production needed to make the goods and services.

All firms are owned bu households.

The circular-flow diagram is a model that illustrates how participants in the markets are linked.Like all economic models,the circular-flow diagram is a simplified version of reality.The model is useful to for seeing how product markets,factor markets,and their participants are linked together.

Wages and other payments to the Factors of production

Goods and services

Free market

A market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed

Note that governments in all modern economies intervene more than is consistent with a fully free market.In that sense,we can think os the free market as being a benchmark against which we can judge actual economies.Countries that come closest to the free market benchmark have been more successful than countries with centrally planned economies in providing their people with rising living standards.

Entrepreneur

Someone who operates a business, bringing together the factors of production - labor, capital, and natural resources - to produce goods and services. They are central to working in a market system, because they determine what goods and services they believe consumers want, and they decide how to produce those goods and services most profitably.

The legal basis of a successful market system:

1. Protection of Private Property

Property rights are the rights individuals or firms have to the exclusive use of their property, including rights to buy or sell it. Property can be tangible, physical property, or intangible, such as the right to an idea.

In any modern economy,intellectual property rights are very important.Intellectual property includes books,films,software,and ideas for new products or new ways of producing products.To protect intellectual property,the government grants patents that gives an inventor –which is often a firm –the exclusive right to produce and sell a new product for a period of 20 years from the date the product was invented.The government grants patents to encourage firms to spend money on the research and development necessary to create new products.

2. Enforcement of Contracts and Property Rights

Business activity often involves someone agreeing to carry out some action in the future.Usually these agreements take the form of legal contracts.For the market system to work businesses and individuals have to rely on these contracts being carried out.

If property owners feel that their right has been violated, they can go to court to have their right enforced.

Chapter 3 Where Prices Come From: The Interaction of Demand and Supply

Perfectly competitive market

A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market

3.1 The Demand Side of the Market

It is importantto note that when we discuss demend we consider not what a consumer wants to buy but what a consumer is both willing and able to buy.

Demand schedule

A table showing the relationship between the price of a product and the quantity of the product demanded.

Quantity demanded

The amount of a good or service that a consumer is willing and able to purchase at a given price

Demand curve

A curve that shows the relationship between the price of a product and the quantity of the product demanded.

Market demand

The demand by all the consumers of a given good or service.

Law of demand

The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.

The law of demands holds for any market demand curve.Economists have found only a very few exceptions to it.

Substitution effect

The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes.

Income effect

The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.Purchasing power is the quantity of goods a consumer can buy with a fixed amount of income.When the price of a good falls ,the increased purchasing power of consumer’s incomes will usually lead them to purchase a larger quantity of the good.When the price of the good rises,the decreased purchasing power of consumer’s incomes will usually lead them to purchase a smaller quantity of the good.

Note that although we analyze them separately,the substitution effect and the income effect happen simultaneosly whenever a price changes.

Ceteris paribus (“all else equal”) condition

The requirement that when analyzing the relationship between two variables – such as price and quantity demanded – other variables must be held constant.

Ashift of a demand curve is an increase or a decrease in demand.A movement along a demand curve is an increase or a decrease in the quantity demanded.

There are various variables that can shift the market demand:

• Income

Normal good: A good for which the demand increases as income rises and decreases as income falls.

Inferior good: A good for which the demand increases as income falls and decreases as income rises.Note that an inferior good does not mean good of low quality.

• Prices of related goods

Substitutes: Goods and services that can be used for the same purpose. If two products are substitutes, the more you buy of one, the less you buy of the other

Complements: Goods and services that are used together. When two products are complements, the more you buy of one, the more you buy of the other

• Tastes refers to many subjective elements that can enter into a consumer’s decision to buy a product.A consumer’s taste for a product can change for many reasons.Sometimes trends play a substantial role.In general,when consumers’ taste for a product increases, the demand curve will shift to the right, and when consumers’ taste for a product decreases, the demand curve for the product will shift to the left.

• Population and Demographics

Demographics: The characteristics of a population with respect to age, race, and gender. As demographics of a country changes, the demand for particular goods will increase or decrease because different categories of people tend to have different preferences for those goods.

Population: As the population increases, so will the number of customers and as result the demand will increase

• Expected Future Prices – Consumers choose when to buy products, if more customers are convinced that prices will go up in the future, current demand will increase

3.2 The Supply Side of the Market

Just as many variables influence the willigness and ability of consumers to buy a praticular good or service, many variables also influence the willingness and ability of firms to sell a good or a service.The most important of these variables is price.

Quantity supplied

The amount of a good or service that a firm is willing and able to supply at a given price.

Holding everything else constant, when the price of a good rises, producing the good is more profitable, and the quantity supplied will increase.In addition we saw that devoting more and more resources to the production of a good results in increasing marginal cost.With higher marginal costs, firms will supply a larger quantity only if the price is higher.

Supply schedule

A table that shows the relationship between the price of a product and the quantity of the product supplied.

Supply curve

A curve that shows the relationship between the price of a product and the quantity of the product supplied.

Law of supply

The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

If only the price of the product changes, there is a movement along the supply curve, which is an increase or a decrease in the quantity supplied.If any other variables that affect the willigness of firms to supply a good changes, the supply curve will shift, which is an increase or a decrease in supply.When firms increase the quantity of a product that they want to sell at a given price, the supply curve shifts to the right.When firms decrease the quantity of a product that they want to sell at a given price, the supply curve shifts to the left.

There are various variables that can shift the market supply:

• Prices of input

Input: Anything used in the production of a good or service.A change in this factor most likely will cause a shift in the supply curve.

• Technological change: A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of input.Positive technological change occurs whenever a firm is able to produce more output using the same amount of inputs.This shift will occur when the productivity of workers or machnes increases.

Negative technological change is relatively rare,although it could result form a natural disaster or a war that reduces a firm’s ability to as much output with a given amount of inputs.Negative technological change will rise a firm’s costs and the good will be less profitable to produce, causing firm’s supply curve to shift to the left.

• Prices of Substitutes in Production

Substitutes in Production are alternative products a firm could produce

• Number of firms in the market

A change in the number of firms in the market will change supply. When new firms enter a market, the supply curve shifts to the right, and when existing firms leave, or exit, a market, the supply curve shifts to the left.

• Expected Future Prices

If a firm expects an increase of the price in the future, it will decrease the production now and increase it in the future.

3.3 Market Equilibrium: Putting Demand and Supply Together

Market equilibrium

A situation in which quantity demanded equals quantity supplied.

Competitive market equilibrium

An equilibrium in competitive markets ( markets with many buyers and sellers)

Surplus

A situation in which the quantity supplied is greater than the quantity demanded. If firms are producing more than they sell, they have an incentive to decrease the price, which in consequence lead to a higher demand. This adjustment will bring the market back to equilibrium

Shortage

A situation in which the quantity demanded is greater than the quantity supplied. At shortage company will be able to sell their products at a higher price. The result is that less people are able to afford the product and companies are willing to produce more at that price. The shortage will therefore be nullified.

At a competitive market equilibrium, all consumers willing to pay the market price will be able to buy as much of the good as they want, and all firms willing to accept the market price will be able to sell as much of the product as they want. As a result, there will be no reason for the price to change unless either the demand curve or the supply curve shifts.

Keep in mind that the interaction of the demand and supply determines the equilibrium price. Neither consumers nor firms can dictate what the equilibruim price will be.No firm can sell amything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.

The effect of shifts in supply on equilibrium

When the supply curve shifts to the right, there will be a surplus at the original equilibrium price. This surplus is eliminated as the equilibruim price falls and the equilibrium price rises. If existing firms exit the market, the supply curve will shift to the left, causing the equilibrium price to rise and the equilibrium quantity to fall.

The effect of shifts in demand and supply over time

In many markets the demand curve shifts to the right over time, as population and income grow.The supply curve also often shifts to the right as new firms enter the market and positive technology change occurs. Whether the equilibrim price in a market rises or falls over time depends on whether demand shifts to the right more than does supply. When denand shifts to the right more than supply, the equilibruim price rises. When supply shifts to the right more than demand, the equilibruim price falls. If the demand curve shifts to the right and the supply curve shifts to the right too, the equilibrium quantity will increase, while the equilibrium price may increase, decrease, or remain unchanged.

Remember: When analyzing markets using demand and supply curves, it is important to remember that when a shift in the demand or supply curve causes a change in equilibrium price, the change in price does not cause further shift in demand or supply.

Chapter 4 Economic Efficiency, Government Price Setting, and Taxes

4.1 Consumer Surplus and Producer Surplus

Consumer surplus

The difference between the highest price a consumer is willing to pay for a good or service and the price the consumer is actually paying. It measures the net benefit to customers from participating in a market rather than the total benefit

Marginal benefit

The additional benefit to a consumer from consuming one more unit of a good or service. The demand curve shows the marginal benefit received by onsumers.

Marginal cost

The additional cost to a firm of producing one more unit of good or service

The willingness to supply a product depends on the cost of producing it. Firms will supply an additional unit of a product only if they receive a price equal to the additional cost of producing that unit.

The supply curve is also a marginal cost curve.

Producer surplus

The difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives. The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price. It measures the net benefit received by producers from participating in a market. A higher price will increase the producer surplus.

4.2 The Efficiency of Competitive Markets

Equilibrium in a competitive market results in the economically efficient level of output, where marginal benefit equals marginal cost.

Economic surplus

The sum of consumer surplus and producer surplus. In a competitive market, economic surplus is at a maximum when market is in equilibrium.Economic surplus is the best measure that we have of he benefit to society from the production f a particular good or service.

Deadweight loss

The reduction in economic surplus resulting from a market not being in competitive equilibrium

Equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service

Economic efficiency

A market outcome in which marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum.

Equilibrium in a competitive market results in the economically efficient level of output, where marginal befit equals marginal cost. Equilibrium in a competitive market results in the greatest amount of economicsurplus, or total net benefit to society, from the production of a good or service.

4.3 Government Intervention in the Market: Price Floors and Price Ceilings

Producers and consumers who are dissatisfied with the competitive equilibrium price can ask the government to legally require that a different price be charged.

Price floor

Government requires a price above equilibrium

Price ceiling

Government requires a price below equilibrium

Unfortunately, whenever a government imposes a price ceiling, a price floor or a tax there are predictable negative economic consequences, because they reduce economic efficiency.

When the government a price ceiling or a price floor, the amount of economic surplus in a market is reduced – in other words, price ceilngs and price floors reduce the total benefit of consumers and firms from buying and selling in the market.

Support for governments setting price floors typically comes from sellers, and suport for governments etting price ceilings typically comes from consumers.

Black market

A market in which buying and selling take place at prices that violate government price regulations

Results of Government price control:

• Some people win

• Some people lose

• Loss of economic efficiency

4.4 The Economic Impact of Taxes

Taxes have the ability to shift the supply curve because it causes a loss in consumer surplus and in producer surplus. The deadweight loss from a tax is referred to as excess burden. A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.

Tax incidence

The actual division of the burden of a tax between buyers and sellers at the market

Note that we have not concluded that every individual s better off if a market is at competitive equilibrium. We have only concluded that the economic surplus, or total net benefit is to society, is greatest at competitive equilibrium.

Chapter 5 Firms, the Stock Market, and Corporate Governance

5.1 Types of Firms

Sole proprietorship

A firm owned by a single individual and not organized as a corporation. Often sole proprietorship is small, but they can make a lot of profit and have many employees

Partnership

A firm owned jointly by two or more persons and not organized as a corporation. The law and accounting firms are partnerships

Corporation

A legal form of business that provides owners with protection from losing more than their investment should the business fail. Under the corporate form of the business , the owners of a firm have limited liability, which means that if the firms fail, the owners can never lose the more than the amount they invested int he firm. The personal assets of the owner of the firm are not affected by the failure of the firm. In fact, in the eyes of the law, a corporation is legal „person”, separate from its owners

In sole proprietorships and partnerships there is no real distinction between personal assets and assets of the firm.

Asset

Anything of value owned by a person or a firm

Limited liability

The legal provision that shields owners of a corporation from losing more than they have invested in the firm

5.2 The Structure of Corporations and the Principal-Agent Problem

Corporate governance

The way in which a corporation is structured and the effect a corporation’s structure has on the firm’s behavior

Shareholders

Owners of the corporation’s stock, who do not manage the firm directly but elect a board of directors, who appoints the Chief Executive Officer (CEO)

Outside directors

Members of the board of directors who do not have a direct management role in the firm

Inside directors

Members of management serving the board of directors

Unlike the owners of family businesses and private firms, such as Facebook, the top management of a large corporation does not generally own a large share of of the firm’s stock, so large corporations have a separation of ownership from control.

Separation of ownership from control

A situation in a corporation in which the top management, rather than the shareholders, control day-to-day operations

Principal-agent problem

A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him

To solve this problem, many firms tie the salaries of top managers to the profit of the firm or the price of the firm’s stock

5.3 How Firms Raise Funds

Owners and managers of firms try to earn a profit. To earn a profit, a firm must rise funds to pay for its operations, including paying its employees and buying machines. Indeed a central challenge for anyone running a firm whether that person is sole proprietor or a top manager of a large corporation, is raising the funds needed to operate and expand the business.

Firm can raise funds in three ways:

Source funds for owners of small business

1. Retained earnings

Reinvest the profit made back into the firm

2. Increasing financial capital

Recruiting additional owners to invest in the firm.This arrangement would increase the firm’s financial capital.

3. Borrow funds

Borrow funds from, relatives, friends or a bank

There are more ways for managers to raise funds.

External funds

Raise funds from others who are able to invest

It is the role of economy’s financial system to transfer funds from savers to borrowers- directly through financial markets or indirectly through financial intermediaries such as banks.

1. Indirect finance

A flow of funds from savers to borrowers through financial intermediaries such as banks, Intermediaries raise funds from savers to lend to firms (and other borrowers)

2. Direct finance

A flow of funds from savers to firms through financial markets, such as New York Stock Exchange. It usually takes form of a financial security, a document that states the terms under which the funds have passed from buyer to borrower. Bonds and stocks are two types of financial securities.

Typically, only large corporations are able to sell bonds and stocks on financial markets. Investors are generally unwilling to buy securities issued by small and medium sized firms because investors lack sufficient information on the financial health of small firms.

Bond – A financial security that represents a promise to repay a fixed amount of funds

Coupon payment – An interest payment on a bond

Interest rate – The cost of borrowing funds, usually expressed as a percentage of the amount borrowed

Stock – A financial security that represents partial ownership of a firm

Dividends – Payment by a corporation to its shareholders

Note that under the law, corporations must make payments on any debt they have before making payments to their owners.Tha is, a corporation must make promise paymnets to bondholders before it can make any divident payments to shareholders.

Unlike bonds, stocks do not have a maturity date, so the firm is nt obliged to return the investor’s at any particular date.

Primary markets

Primary markets are those in which newly issued claims are sold to initial buyers by the issuer.Businesses can rise funds only the first time they issue a stock in the market. Although we hear about the stock market fluctuations each night on the vening newa, bonds actually account for more of the funds raised by borrowers.

Secondary markets

In secondary markets, stocks and bonds that have been already issued are sold by one investor to anoher. In secondary markets firms does not rise funds.

Primary ad econdary markets are both importants, but they play different roles. As an investor, you principally trade stocks and bonds in a secondary market. As a corporate manager, you may help decide how to raise new funds to expand the firm where you work.

A higher bond price idicates a lower cost of new external funds, wile a lower bond price indicates a higher cost of new external funds.

Stock market indexes

Average of the stock price with the value of the index set equal to 100 in a particular year, called the base year.

The three most followed stock indexes:

1. Dow Jones Industrial Average

Index of stock prices of 30 large US corporations

2. S&P 500

Index prepared by the Standard and Poor’s company and includes the stock prices of 500 large US firms

3. NASDAQ

Index of stock prices of more than 4000 firms whose shares are traded in the NASDAQ (National Association of Security Dealers). The listings on NASDAQ are dominated by high-tech firms.

We would expect that stock prices will rise whne the economy is expanding, an fall when the economy is in recesion.

Remember that because firms retain some earnings, earnings per share is not the same as dividents per share.

5.4 Using Financial Statements to Evaluate a Corporation

Income statement

A financial statement that sums up a firm’s revenues, costs, and profit over a period of time. Corporations issue annual income statements, although the 12-month pfiscal year covered may be different from the calendar year to better represent the seasonal patern of the business.

Accounting profit

A firm’s net income, measured by revenue minus operating expenses and taxes paid

Opportunity cost

The highest-valued alternative that must be given up to engage in an activity.Economist always measure costs as opportunity cost.

By taking into account all cost, economic profit provides a better indication than accounting profits of how successful a firm is.

Explicit cost

A cost that involves spending money

Implicit cost

A nonmonetary opportunity cost

Economic cost

Economic cost include both implicit and ecplicit costs.

Economic profit

A firm’s revenues minus all of its explicit costs

Normal rate of return

The minimum amount that investors must earn on the funds they invest in a firm, expressed as a percentage of the amount invested. The necessary rate of return that investors must receive to continue investing in a firm varies from a firm to firm

Balance sheet

A financial statement that sums up a firm’s financial position on a particular day, usually the end of a quarter or a year

Chapter 6 Comparative Advantage and the Gains from International Trade

6.1 The United States in the International Economy

In the past 50 years, many governments have changed policies to facilitate international trade by for instance, tariff rate reductions and free trade agreements such as the North American Free Trade Agreement (NAFTA) or European Union, which eliminates all tariffs among member countries.

Tariff

A tax imposed by government on imports

Imports

Goods and services bought domestically but produced in other countries

Exports

Goods and services produced domestically but sold in other countries

Govenments are more likely to interfere with international trade than they are with domestic trade, but the reasons for the interference are more political than economic.

6.2 Comparative Advantage in International Trade

Recalling the concepts of comparative advantage and opportunity cost.

Comparative advantage

The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors

Opportunity cost

The highest-valued alternative that must be given up to engage in an activity

In trading, we benefit from the comparative advantage of other people and they benefit from our comaparative advantage.

Absolute Advantage

The ability to produce more of a good or service than competitors when using the same amount of resources

6.3 How Countries Gain from International Trade

Autarky

A situation in which a country does not trade with other countries

Terms of trade

The ratio at which a country can trade its exports for imports from other countries

Countries gain from specializing in producing goods which they have a comparative advantage and trading for goods in which other countries have a comparative advantage.

There are 3 reasons why complete specialization do not exist:

1. Not all goods and services are traded internationally

2. Production of most goods involves increasing opportunity cost

3. Tastes for products differ, most products are differentiated

The sources of comparative advantage are the following:

1. Climate and natural resources

2. Relative abundance of labor and capital

3. Technology – Product development technology and process technology

4. External economies – Once an industry becomes established in an area, firms that locate in that area gain advantage over firms located elsewhere. The advantages include the availability of skilled workers, the opportunity to interact with other firms in the same industry, and proximity to suppliers.

Once a country has lost its comparative advantage in producing a good, its income will be higher and its economy will be more efficient if it swithes from producing the good to importing it.

6.4 Government Policies That Restrict International Trade

Free trade

Trade between countries that is without government restrictions

International trade helps consumers by increasing consumer surplus, but hurts firms by decreasing producer surplus. This is the reason why firms and their employees are strong supporters of government policies that restrict trade. There are two forms of policies:

• Tariff increases

Succeeds in helping producers but hurts and the efficiency of the economy

• Quotas and Voluntary Export Restraints

Quota – A numerical limit imposed by a government on the quantity of a good that can be imported into the country

Voluntary export restraint (VER) – An agreement negotiated between two countries that places a numerical limit on the quantity of a good that can be imported by one country from the other country

Quotas ans VERs have similar economic effect.

The main purpose of most tariffs and quotas is to reduce the foreign competition that domestic firms face. The US economy would gain from the elimination of tariffs and quotas even if other countries do not reduce their tariffs and quotas.

Other barriers to trade

All governmnets require that imports meet certain health and safety requirements.

6.5 The Argument Over Trade Policies and Globalization

World Trade Organization (WTO)

An international organization that oversees international trade agreements, currently 150 countries are members of the WTO

Globalization

The process of countries becoming more open to foreign trade and investment.

Globalization has increased the variety of products available to consumers in developing countries, but some argue that this is too high price to pay for what they see as damage to local cultures.Globalization has allowed multinational corporations to relocate factories form high-income countries to low income countries.

Protectionis

The use of trade barriers to shield domestic firms from foreign competition

Main arguments for Protectionism:

• Saving jobs

Counter-argument: Job losses are rarely permanent, Jobs are lost and new jobs are created continually

• Protecting high wages

Counter-argument: Free trade enhances living standards by increasing economic efficiency. If protectionism would be applied, which means producing goods within the home country, opportunity cost will be very high

• Protecting infant industries

Counter- argument: Even when time is given, infant industries never grew up,and they continued for years as inefficient drains on their economies

• Protecting national security

Dumping

Selling a product for a price below its cost of production.Although allowable under the WTO agreement, using tarrifs to offset the effects of dumpling is very controversial. In practice, it is difficult to determine whether foreign companies are dumpling goods because the true production costs of a good are not easy for foreign governments to calculate.

Chapter 7 GDP: Measuring Total Production and Income

7.1 Gross Domestic Product Measures Total Production

Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. In the macroeconomic analysis, economists study factors tht affect many markets at the same time.

The business cycle refers to the altering periods of expansion and recession.

A business cycle expansion is a period in which total production and total employment are increasing.

A business cycle recession is a period in which total production and employment are decreasing.

Economic growth refers to the ability of an economy to produce increasing quantities of goods and services. Economic growth is important because an economy that grows too slowly fails to rise living standards.

Note that in the short run the level of employment is significantly affected by the business cycle, but in the long run, the effects of the business cycle disappear, and other factors determine the level of emplyment.

Inflation rate is the percentage increase in the average level of prices from year to the next.

Gross Domestic Product (GDP)

The market value of all final goods and services produced in a country during a period of time, typically one year, it is measured using market values, not quantities.

When we measure the total production in the economy, we can’t just add together the quantities of every good and service because the result will be meaningless jumble. Tons of wheat would be added to gallons of milk, number of passengers on flights, and so on. Instead we measure production by taking the value, in dollar terms, of all the goods and services produced.

Note that when we measure the value of total production in the economy by calculating GDP, we are simultaneously measuring the value of total income. Every penny must end up as someone’s income. Therefore, if we add up the value of every good and service sold in the economy, we must get a total that is exactly equal to the value of all income in the economy.

Final good or service

A good or service purchased by a final user

Intermediate good or service

A good or service that is an input into another good or service, such as tire on a truck

Transfer payments

Payments by the government to individuals for which the government does not receive a new good or service in return. Include social security payments to retired and disabled people and unemployment insurance payments to unemplyed workers. Thus, these payments are not included in the calculation of the GDP.

Note that when we can measure GDP either by calclating the total value of expenditures on final goods and services or by calculating the value of the total income. We get the same dollar amount of GDP with either approach.

The GDP can be divided into 4 categories:

1. Consumption: Spending by households on goods and services not including spending on new houses. Makes out the biggest part in GDP, especially the service sector

2. Services e.g. Haircuts

3. Nondurable goods e.g. Food

4. Durable goods e.g. Furniture and automobiles

2. Investment: Spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses

3. Business fixed investment: Spending by firms on new factories etc. Make out largest part of Investment sector

4. Residential investment: Spending by households and firms on houses

5. Changes is business inventories: Products that are produced but not yet sold

3. Government purchases: Spending by federal, state and local governments on goods and services. E.g. Teachers’ salaries or highways

4. Federal

5. State and local: Largest component in government purchases

4. Net exports: Export minus imports. Imports are greater than exports in the American market

Equation for GDP

Y = C + I +G +NX

Y= GDP

C= Consumption

I= Investment

G= Government purchases

NX= Net exports

Value added

The market value a firm adds to a product

One can also calculate the GDP by adding up the value added of every firm involved in producing those final goods and services.

Remeber what economists mean with the word investment: Investment is for purchases of machinery, factories, and houses. Economists don’t include purchases of stock or rare coins or deposits in saving accounts in the definition of investment because these activities don’t result in the production of new goods.

Some interesting points of GDP:

• Consumer spending on service is greater than the sum of spending on spending on durable and nondurable goods

• Business fixed investment is the largest component of investment

• Purchases made y tate and local governments are greater than purchases made byederal government

• Imports are greater than exports, so net exports are negative

7.2 Does GDP Measure What We Want IT to Measure?

When the Bureau of Economic Analysis (BEA) calculates the GDP, it does not include two types of production:

• Household Production: Goods and services people produce for themselves, personal use

• Underground Economy: Buying and selling goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal

Shortcomings of GDP as a Measure of Well-Being

• The value of leisure is not included in GDP

• GDP is not adjusted for pollution or other negative effects of production

• GDP is not adjusted for changes in crime and other social problems

• GDP measures the size of the pie but not how the pie is divided up

To summarize, we can say that a person’s well-being depends on many factors that are not considered in calculating GDP. Because GDP is designed to measure total production, it should not be surprising that it does an imperfect job of measuring well-being.

7.3 Real GDP versus Nominal GDP

Nominal GDP

The value of final goods and services evaluated at current-year prices

Real GDP

The value of final goods and services evaluated at base-year prices

By keeping prices constant, we know that changes in real GDP represents chamges in the quantity of goods and services produced in the economy.

Price level

A measure of the average prices of goods and services in the economy

GDP deflator

A measure of the price level calculated by dividing nominal GDP by real GDP and multiplying by 100

7.4 Other Measures of Total Production and Total Income

Gross National Product (GNP)

The value of final goods and services produced by residents of a country, even if production takes place outside of that country

National Income

The value when consumption of fixed capital is subtracted from the GDP. Consumption of fixed capital refers to worn-out machinery, equipment and buildings that have to be replaced

Personal income

Income received by households.

Disposable personal income

Personal income minus personal tax payments, best measure of the income households actually have available to spend

Chapter 8 Unemployment and Inflation

8.1 Measuring the Unemployment Rate and the Labor Force Participation Rate

Labor force

The sum of employed and unemployed workers in the economy

Unemployment rate

The percentage of the labor force that is unemployed

People who don’t have a job and are not activelly looking for a job are classified as not in the labor force. People not included in the labor force include retires, homemakers, full-time students, and people on active military service, in prison, or mental hispitals. Also people who are available for work and who were activelly looking for a job at some point during the previous 12 months but who have not looked during the previous 4 weeks.

Discouraged workers

People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them

The unemployment rate

Measures the percentage of the labor force that is unemployed

Unemployment rate = (Number of unemployed/Labor force) x 100

The labor force participation rate

Measures the percentage of the working-age population that is in the labor force

Labor participation rate = (Labor force/Working-age population) x 100

There are two problems with measuring the unemployment rate, it does not include discouraged workers as unemployed and it counts people as employed who are working part-time, although they would prefer to be working full-time.

Ordinary, the typical person who loses a job will find another one or be recalled to a previous job within a few months.

Labor force participation rate is important because it determines the amount of labor that will be available to the economy from a given population. The higher the labor force participation rate, the the more labor will be available and the higher the country’s level of GDP and GDP per capita will be.

Although the unemployment rate provides some useful information about the employment situation in the country, it is far from an exact measure of joblessness in the economy.

Note that different groups in the polulation can have different unemployment rates.

The Establishment Survey

Measures total employment in the economy, by sampling about 300.000 business establishments; it has three major drawbacks:

• Does not provide information on number of self-employed persons because they are not on company’s payroll

• May fail to count some person employed at newly open firms that are not included in the survey

• Provides no information on unemployment

Notece that the household survey, because it includes the self-employed gives a larger total for employment than does the establishment survey. The household survey provides information on the number of persons unemployed and on the number of persons in the labor force.

Job creation and job destruction over time

The creation and destruction of jobs results from changes in consumer tastes, technological progress, and the successes and failures of entrepreneurs in responding to the opportunities and challengess of shifting consumer tastes and technological change.

8.2 Types of Unemployment

1. Frictional unemployment

Short-term unemployment that arises from the process of matching workers with jobs

Can be caused through:

• Seasonal unemployment: Unemployment due to factors such as weather, variations in tourism, and other calendar related events

The process of job search takes time, so there will always be some workers who are frictionally unemployed because they are between jobs and in the process of searching for new ones.

2. Structural Unemployment

Unemployment arising from a persistent mismatch between the skills and attributes of workers and the requirement of jobs.

Some workers lack even basic skills, such as literacy, or have addictions to alcohol or other drugs that make it difficult for them to perform adequately the duties of almost all jobs. These workers may remain structurally unemployed for years.

3. Cyclical Unemployment

Unemployment caused by a business cycle recession

4. Full Employment

Economy is said to be at full employment, when the only remaining unemployment is structural and frictional unemployment.

Natural rate of unemployment

The normal rate of unemployment, consisting of frictional unemployment plus structural unemployment, also referred to as full-employment rate of unemployment

8.3 Explaining Unemployment

There are several factors influencing the levels of frictional and structural unemployment:

1. Government Policies and the Unemployment Rate

2. Unemployment insurance and other payments to the unemployed

3. Social insurance programs

4. Minimum wage laws

2. Labor unions

Organizations of workers that bargain with employers for higher wages and better working conditions for their members

3. Efficiency wages

A higher-than-market wage that a firm pays to increase worker productivity

By paying a wage above the market wage, the firm raises the costs to workers of loosing their jobs because most alternative jobs will pay only the market wage. The increase in productivity that results from paying the high wage can more than offset the extra cost of the wage, thereby lowering the firm’s cost of production.

8.4 Measuring Inflation

Inflation rate

The percentage increase in the price level from one year to the next

Consumer price index (CPI)

An average of the prices of the goods and services purchased by the typical urban family of four, sometimes referred to cost-of-living index; it is the most widely used measure for inflation

The thing to notice is that the CPIs are index numbers, which means that they are not measured in dollars or any other units. CPI is intended to measure changes in the price level over time. We can not use CPI to tell us in absolute sense how high the price level is, only how much it has changed over time.

CPI = (Expenditures in the current year/ Expenditures in the base year) x 100

There are four biases that can influence the true inflation rate

1. Substitution bias: Consumers are likely to buy fewer of those products that increase most in price and more of those products that increase least in the price

2. Increase in quality bias: Increases in the price of improved products partly reflect their enhanced quality and are partly pure inflation

3. New product bias: New products are not included in the market basket. If market basket is not updated frequently price decreases caused by new products are not included in the CPI

4. Outlet bias: From the mid-1990s, many outlet stores crowded the market, but BLS continued to collect price statistics from traditional full-priced retail stores, the CPI did not reflect the prices some customers actually paid

Producer price index (PPI)

An average of the prices received by producers of goods and services at all stages of the production process

The PPI includes the prices of raw materials and intermediate goods.

Note that a change in the PPI therefore can give an early warning of future movements in the CPI.

8.5 Using Price Indexes to Adjust for the Effects of Inflation

Price indexes such as the CPI give us a way of adjusting for the effects of inflation so that we can compare dollar values from different years.

This equation can calculate how high the value in a certain time back is in terms of today’s value:

Today’s value = Past value x (CPI of today/CPI of past)

8.6 Real versus Nominal Interest Rates

Nominal interest rate

The stated interest on a loan

Real interest rate

The nominal interest rate minus the inflation rate

Real interest rate = Nominal interest rate – Inflation rate

The real in interest rate provides a better measure of the true cost of borrowing and the true return from lending than does the nominal interest rate.

Deflation

A decline in the price level

Menu cost

The costs to firms of changing prices

At moderate levels of anticipated inflation, manu costs are relatively small, but at very high levels of inflation, such as those experienced in some developing countries, manu costs and the costs due o paper money loosing value can become substantial.

Chapter 9 Economic Growth, the Financial System, and Business Cycles

Increasing production faster than population growth is the only way that standart of leaving of the average person in a country can increase. The best measure of the standard of leaving is real GDP per person. It is the upward trend in real GDP per capita that we focus on when we discuss long-run economic growth.

Business cycle

Alternating periods of economic expansion and economic recession. It is not uniform, each period of expansion is not the same length, nor is each period of recession. But every period of expansion is followed by a period of recession, and every period of recession is followed by a period of expansion

9.1 Long-Run Economic Growth

Long-run economic growth

The process by which rising productivity increases the average standard of living; measured by real GDP per capita

Rule of 70

Calculates how many years it will take for the real GDP per capita to double

Number of years to double = ,70-/Growth rate.

Notice that the rule of 70 applies not just to growth in real GDP per capita but to growth in any variable.

Labor productivity

The quantity of goods and services that can be produced by one worker or by one hour of work. In analyzing long-run growth, economists usually measure labot productivity as output per hour of work to avoid the effects of fluctuations in the length of the workday and in the fraction of the population employed.

Increases in real GDP per capita depend on increases in labor productivity. There are two factors that determine labor productivity:

1. Increases in capital per hour worked

- Capital: Manufactured goods that are used to produce other goods and services

- Capital stock: Total amount of physical capital available e.g. computers or tools. As the capital stock per hour worked increase, worker productivity increases.

- Human capital: Accumulated knowledge and skills workers acquire from education and training or from their life experience. Increases in human capital are particularly important in stimulating economic growth.

2. Technological Change: Increase in the quantity of output firms can produce using a given quantity of input; to increase economic growth technological change is a necessity. In implementing technological change, entrepreneurs are of crucial importance.

3. Supportive government policies

Potential GDP

The level of real GDP attained when all firms are producing at capacity

9.2 Saving, Investment, and the Financial System

Remember that the total value of saving in the economy must equal to the total of investments.

The relationship between GDP and its components can be described using the formula:

Y=C+I+G+NX

Where: Y is GDP; C is consumption; I in investment, G is government purchases, NX is net exports.

Open economy

In an open economy there is interaction with other economies in terms of both trading of goods and servicing and borrowing and lending.

In closed economies, net exports are zero, so we rewrite the equation:

Y=C+I+G

Financial system

The system of financial markets and financial intermediaries through which firms acquire funds from households

Financial markets

Markets where financial securities, such as stocks and bonds, are bought and sold

Financial intermediaries

Firms, such as banks, mutual funds, pension funds, and insurance companies that borrow funds from savers and lend them to borrowers

Market for loanable funds

The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. Demand for loanable funds is determined by the willingness of firms to borrow funds, which is in turn determined by the interest rate. The demand is determined by the willingness of households to save and to which extent the government is saving.

Note that the equilibrium in the market for loanable funds determines the real interest rate rather than the nominal interest rate.

Furthermore, an increase in the quantity of loanable funds means that both the quantity of savings by households and the quantity of investment by firms have increased.

Crowding out

A decline in private expenditures as a result of an increase in government purchases

In practise, however, the impact of government budget deficits and surpluses on the equilibrium interest rate is relatively small.

9.3 The Business Cycle

The business cycle is usually illustrated using movements in real GDP.

Expansion phase

Production, employment, and income are increasing

Recession phase

Production, employment and income are declining. It ends when another period of expansion begins

Each business cycle is different. The length of the expansion and recession phases and which sectors of the economy are most affected are rarely the same in any two cycles. As the economy nears the end of the expansion phase, interest rates are usually rising, and the wages of workers are ususally rising faster than prices..

The effect of the business cycle on

1. Inflation rate: Increases during expansion and decreases during recession

2. Unemployment rate: Increases during recession and decreases during expansion

Note also that durables are affected more by the business cycle than are nondurables.

Another fact to remember is that during economic expansion, the inflation rate usually increases, particularly near the end of the expansion, and during recessions, the inflation rate usually decreases.

Reasons economy became more stable:

• The increasing importance of services and the decreasing importance of goods

• The establishment of unemployed insurance and other government transfer program that provide funds to the unemployed

• Active federal government policies to stabilize the economy

• Increased stability of the financial system

Chapter 10 Long-Run Economic Growth: Sources and Policies

10.1 Economic Growth over Time and around the World

An important poin to always keep in mind is that: In the long run, small differences in economic growth rates result in big differences in living standards. Growth rates matter because if an economy grows too slowly fails to rise living standards.

Industrial revolution

The application of mechanical power to the production of goods, beginning in England around 1750

The real GDP per capita determines the economic growth. In the long run, small differences in economic growth rates result in big differences in living standards.

High-income countries

Countries with a high real GDP per capita also referred to as the industrial countries. Such as Western Europe, Australia, Canada, Japan, New Zealand and the US

Developing countries

Countries with a low real GDP per capita, including most countries in Africa, Asia, and Latin America

Newly industrializing countries

Countries that experienced a high rate of growth during the 1980s and the 1990s; e.g. Singapore, South Korea, or Taiwan

10.2 What determines How Fast Economies Grow?

Economic growth model

A model that explains growth rates in real GDP per capita over the long run

Labor productivity

The quantity of goods and services that can be produced by one worker or by one hour of work

Technological change

A change in the quantity of output a firm can produce using a given quantity of inputs

There are three main sources of technological change:

1. Better machinery and equipment

2. Increases in human capital: The accumulated knowledge and skills that workers acquire from education and training or from their life experience

3. Better means of organizing and managing production

Per-worker production function

The relationship between real GDP per hour worked and capital per hour worked, holding the level of technology constant

When holding technology constant, however, equal increases in the amount of capital per hour worked lead to diminishing increases i output per our worked. In fact, at very high levels of capital per hour worked, further increases in capital per hour worked will not result in any increase in real GDP per hour worked.

Technological change helps economies avoid deminishing returns to capital. The replacement of exisiting capital with more productive capital is an example of technological change. Another example is recognizing how production takes place so as to increase output. Because of diminishing returns to capital, continuing increases in real GDP per hour worked can be sustained only if there is technological change.

New growth theory

A model, developed by Paul Romer, of long-run economic growth that emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system. Increase in capital per hour worked lead to increases in real GDP per hour worked but at a decreasing rate. Romero argues that the same is true for knowledge capital at the firm level. Because knowledge capital is nonrival and nonexcludable, firms can free rideon the research and development of other firms. Firms free ride when they benefit from the results of research and development they did not pay for. Romero point out that firms are unlikely to invest in research and development up to the point where the marginal cost of the research equals the marginal return from the knowledge gained because much of the marginal return will be gained by other firms.

There are three ways how government helps to increase the accumulation of knowledge capital:

1. Protecting intellectual property with patents and copyrights

2. Subsidizing research and development

3. Subsidizing education

Patent

The exclusive right to produce a product for a period of 20 years from the date the product is invented

10.4 Why isn’t the Whole World Rich?

Catch-up

The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries

Looking only at the countries that currently have high incomes, the lower-income countries have been catching upto the higher-income contries, but the developing countries as a group have not been catching up to the high-income countries as a group.

Low-Income Countries experience less rapid growth because of four factors:

1. Failure to enforce the rule of law

2. Property rights: The rights individuals or firms have to the exclusive use of their property including the right to buy or sell it

3. Rule of law: The ability of a government to enforce laws of the country, particularly with respect to protecting private property and enforcing contracts

2. Wars and revolutions

3. Poor public education and health

4. Low rates of Saving and investments

Globalization

Globalization refers to the prcess of countries becoming more open to the foregn trade and investment.

Foreign direct investment (FDI)

The purchase or building by a corporation of a facility in a foreign country

Foreign portfolio investment

The purchase by an individual or a firm of stocks or bonds issued in another country

Foreign direct investments and foreign portfolio investments can give a low-income countries access to funds and technology that otherwise would not be available

10.4 Growth Policies

In order to promote long-run economic growth, there are a few policies that have to be followed:

• Enhancing property rights and the rule of law

• Improving health and education

• Policies that promote saving and investment

• Policies that promote technological change

The brain drain refers to highly educated and successful individuals leaving developing countries for high-income countries. This migration occurs when successful individuals believe that economic opportunites are very limited in the domestic country.

Remember that technological change is more important than increases in capital in explaining long-run growth. Government policies that facilitate access to technology are crucial for low-income countries. The easiest way for developing countries to gain access to technology is through foreign direct investment where foreign firms are allowed to buld new facilities or to buy domestic firms. Furthermore, investment tax credits allow firms to deduct from their taxes some fraction of the funds they have spent on investment. Reduction of the taxes firms pay on their profits also increase the after-tax return on investment.

Chapter 12 Aggregate Demand and Aggregate Supply Analysis

12.1 Aggregate Demand

Aggregate demand and aggregate supply model

A model that explains short-run fluctuations in real GDP and the price level

Real GDP and the price level in this model are determined in the short run by the intersection of the aggregate demand curve and the aggregate supply curve. Fluctuations are caused by shifts in the aggregate supply curve or in the aggregate demand curve.

Aggregate demand curve

A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government; labeled as AD

Short-run aggregate supply curve

A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms; labeled as SRAS

Even though the aggregate demand and supply model looks very similar to the individual market demand and supply curve, this model refers to the whole economy whereas the individual market demand and supply curve deals with individual markets.

The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded. There are three factors, which can explain why the price level influence the quantity of real GDP demanded:

1. Wealth Effect: Change in price level influence consumption

Current income is the most important variable determining the consumption of households. As total household’s wealth rises, consumption will rise. When price value rises, the real value of household wealth declines, and so will consumption, thereby reducing the demand for goods and services. When price level falls, the real value of household wealth rises, and so will consumption and the demand for goods and services.The impact of the price level on consumption is called the wealth effect, and is one reason why the aggregate demand curve is downward slopping.

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2. The Interest-Rate Effect: Change in the price level influence investment

A higher price level increases the interest rate and reduces investment spending, it also reduces the quantity of goods and services demanded. A lower price level will decrease the interest rate and increase investment spending, thereby increasing the quantity of goods and services demanded. A lower price level will decrease the interest rate and increases investment spending, thereby increasing the quantity of goods and services demanded. This impact of the price level on investment is known as the interest rate effect, and is the secon reason why the aggregate demand curve is downward slopping.

3. The International-Trade Effect: Change in the price level influence net export

A higher price level relative to other countries will cause the domestic export to become more expensive than the imports, which in turn shifts the demand from buying domestic products. A lower price in the domestic country compare to foreign countries has the reverse effect, causing net exports to rise, increasing the quantity of goods and services demanded. This imapct of the price level on net exports is known as the international-trade effect, and it is the third reason why the aggregate demand curve is sownward slopping.

An important point to remeber is that the aggregate demand curve tells us the relationship between the price level and quantity of real GDP demanded, holding everything else constant. If price level changes but other variables that affect the aggregate demand curve remain unchanged, the economy will move up or down a stationary aggregate demand curve. If any variable other than the price level changes, the aggregate demand curve shifts.

There are three variables that cause the aggregate demand curve to shift:

1. Changes in government policies

Monetary policy – The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth

Fiscal policy – Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives; increase in personal taxes shifts the demand curve to the left, lower personal income tax shifts aggregate demand to the right

2. Changes in the Expectation of Households and Firms

If households are optimistic about their future incomes, they are likely to increase their current consumption, which will shift the demand curve to the right. If they become more pessimistic, they will reduce their consumption, which will shift the aggregate demand curve to the left.

3. Changes in Foreign Variables

An increase in the net export at every price level will shift the aggregate demand curve to the right. Net export will increase if real GDP grows more slowly in the domestic country than in foreign countries or if the value of the domestic currency falls against other currencies.

12.2 Aggregate Supply

Remember: In the long run, changes in the price level do not affect the level of real GDP. Real GDP in the long run will be called potential GDP or full-employment GDP

Long-run aggregate supply curve

A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied, labeled as LRAS

The long-run aggregate supply curve shifts to the right each year. This shift occurs because potential real GDP increases each year, as the number of workers in the economy increases, the economy accumulates more machinery and equipment, and technological change occurs.

The short-run aggregate supply curve is upward sloping, because over the short run, as price level increases the quantity of goods and services firms are willing to supply will increase. Some firms adjust their prices more slowly this is because some firms and workers fail to accurately predict changes in the price level, there are three other explanations:

1. Contract make some wages and prices sticky

Prices and wages are said to be sticky when they do not respond quickly to changes in demand or supply, this is for example due to contracts.

2. Firms are often slow to adjust wages

Wages of many union workers remain fixed by contract for several years. If firms are slow to adjust wages, a rise in the price level will increase the profitability of hiring more workers and producing more output. A fall in the price level will decrease the profitability of hiring more workers and producing more output.

3. Menu cost make some prices sticky

Many firms print catalogues that list the prices of their products. If demand for the product is higher or lower than the firms had in their menu, they may want to change prices. Some firms might not want to change prices due to the menu costs during a phase of increasing price levels, because of their low prices; these firms will find their sales increasing

If price level changes but other variables are unchanged, the economy will move up or down a stationary aggregate supply curve. If any variable other than the price level changes, the aggregate supply curve will shift

There are five variables, which can cause the short-run aggregate supply curve to shift:

1. Increases in the labor force and in the capital stock

As the labor force and the capital stock grow, firms will supply more output at every price level, and the short-run aggregate supply curve will shift to the right

2. Technological change

Technological change means increase in productivity, which reduces the firms’ cost of production and, therefore allows them to produce more output at every price level. This will cause the short-run aggregate supply curve to shift to the right.

3. Expected change in the future price level

If workers and firms expect the price level to increase by a certain percentage, the SRAS curve will shift by an equivalent amount, holding all other variables that affect the SRAS curve constant.

4. Adjustment of workers and firms to errors in the past expectations about the price level

If workers and firms across the economy are adjusting to the price level being higher than expected, the SRAS curve will shift to the left. If they are adjusting to the price level being lower than expected, the SRAS curve will shift to the right

5. Unexpected change in the price of an important natural resource

If the price of a natural resource rises, firms have to face rising costs. They will supply the same level of output only if they receive higher prices, and the SRAS curve will shift to the left

Supply shock – An unexpected event that causes the short-run aggregate supply curve to shift. Supply shocks are often caused by unexpected increases or decreases in the price of important natural resources.

12.3 Macroeconomic Equilibrium in the Long Run and the Short Run

We bring the the aggregate demand cure, the short run aggregate supply curve , and the long run aggregate supply curve together in one graph, to show the long-run macroeconomic equilibrium for the economy. Notice that in the long run equilibrium, the short- run aggregate supply curve and the aggregate demand curve intersect at a point on the long run aggregate supply curve. Because equilibrium occurs at a point along the long run aggregate supply curve, we know that the economy is at potential real GDP.

Examination of the short-run and long run effects of recession, expansion, and supply shocks

Recession

During recession the aggregate demand curve will shift to the left. The short-run macroeconomic equilibrium will decline until it is below its potential level. This lower level of GDP will result in declining profitability and layoffs for some workers. In the long-run workers and firms will begin to adjust to the price level lower than they had expected it to be, which will cause the SRAS curve to shift to the right and the economy will be back in the long-run equilibrium. This is referred to as an automatic mechanism.

The inportant conclusion is that a decline in aggregate demand causes a recesion in the short run, but in the long run it causes only a decline in the price level.

Expansion

During expansion the aggregate demand curve will shift to the right. The equilibrium will move up until the economy is above its potential GDP. Firms are operating beyond their normal level of capacity and more people are employed. In the long run firms and workers will begin to adjust to the price level being higher than expected, which will result in a shift of the SRAS curve to the left. At this point the economy will be back in the long-run equilibrium

Supply Shock

If the price of a natural resource increases, the supply curve will cause an increase in many firms’ cost and cause the SRAS to shift to the left. The price level is higher in the new short-run equilibrium, but the real GDP is lower. This is referred to as stagflation.

In the long run the SRAS will shift to the left, resulting in the potential GDP at the original price level.

Stagflation

A combination of inflation and recession, usually resulting from a supply shock

12.4 A Dynamic Aggregate Demand and Aggregate Supply Model

WE can create a dynamic aggregate demand and aggregate supply model by making changes to the basic model that incorporate the following important macroeconomic facts:

• Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right

• During most years, the aggregate demand curve shifts to the right

• Except during periods when workers and firms expect high rates of inflation, the SDAS curve shifts to the right

What is the useual cause of inflation?

If total spending in the economy grows faster than the total production, prices rise. Although inflation is generally caused by total spending growing faster than total production, a shift to the left of the dhort-run aggregate supply curve can also cause an increase in price level. If aggregate demand increases by the same amount as short run and long run aggregate supply, the price level will not change. In this case, the economy experinces economic growth without inflation.

A bubble occurs when people become less concerned with the underlying value of an asset- either a physical asset, such as house, or financial asset, such as a stock- and focus instead on expectations of the price of the asset increasing.

Chapter 13 Money, Banks, and the Federal Reserve System

13.1 What Is Money, and Why Do We Need It?

Money

Assets that people are generally willing to accept in exchange for goods and services or payment of debts

Asset

Anything of value owned by a person or a firm

Barter economies

Economies, where goods and services are traded directly for other goods and services

Double coincidence of wants

For a barter trade to take place between two people, each person must want what the other one has. Locating several trading partners and making several intermediate trades can take considerable time and energy

Commodity money

A good used as money that also has value independent of its use as money

We need money to make exchange easier, money allows for specialization and higher productivity.

The functions of money

1. Medium of money

Money serves as a medium when sellers are willing to accept it in exchange for goods or services. An economy is more efficient when a single good is recognized as a medium of exchange

2. Unit of account

Once a single good is used as money, each good has a single price rather than many prices. This function of money gives buyers and selers unit of account, a way of measuring value in the economy in terms of money.

3. Store of value

If people do not use all their money to buy goods and services today, they can hold the rest to use in future

4. Standard of deferred payment

Money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account. It can facilitate exchange over time by providing a store of value and a standard of deferred payment. E.g. Installments

The following five criteria needs to be fulfilled to be a suitable medium of exchange:

1. The good must be acceptable to (usable by) most people

2. It should be of standardized quality so that any two units are identical

3. It should be durable so the value is not lost by spoilage

4. It should be valuable relative to its weight so that amount large enough to be useful in trade can be easily transported

5. It should be divisible because different goods are valued differently

Federal reserve

The central bank of the United States that is an agency of the government and regulates the money supply

Commodity money

Commodity money has value independent of its use as money, for example gold.

Fiat money

Money, such as paper currency, which has no value except as money, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money

13.2 How Is Money Measured in the United States Today?

M1

The narrowest definition of the money supply: The sum of currency in circulation, checking account deposits in banks, and holdings of traveler’s check

M2

A broader definition of the money supply: It includes M1 plus savings account balances, small-denomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares

There are two key points to remember when dealing with money supply:

1. Money supply consists of currency and checking account

2. Because balances in checking account deposits are included in money supply, banks play an important role in the way the money supply increases and decreases.

13.3 How Do Banks Create Money?

Reserves

Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve

Required reserves

Reserves that a bank is legally required to hold, based on its checking account deposit

Required reserve ratio (RR)

The minimum fraction of deposits bank are required by law to keep as reserves

Excess reserves

Reserves that banks hold over and above the legal requirement

Simple deposit multiplier

The ratio of the amount of deposits created by banks to the amount of new reserves

Simple deposit multiplier = (1/required reserve ratio (also called RR))

Change in checking account deposits = Change in bank reserves x (1/RR)

Whenever banks gain reserves, they make new loans, and the money supply expands.

Whenever banks lose reserves, they reduce their loans, and the money supply contracts.

13.4 The Federal Reserve System

Fractional reserve banking system

A banking system in which banks keep less than 100 percent of deposits as reserves

Bank run

A situation in which many depositors simultaneously decide to withdraw money from a bank. It is possible for one bank to handle a run by borrowing from other banks, but if may banks simultaneously experince runs, the banking system may be in trouble.

Bank panic

A situation in which many banks experience runs at the same time

Acentral bank, like the Federal Reserve in the United States, can help stop a bank panic by acting as a lender from last resort.

Discount loans

Loans the Federal Reserve makes to banks

Discount rate

The interest rate the Federal Reserve charges on discount loans

The first priority of the Federal Reserve System is to stop bank panics by acting as a lender of last resort; today the Fed is also responsible for managing the money supply.

Monetary policy

The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives

To manage the money supply, the Fe uses three monetary policy tools:

1. Open market operations

Federal Open Market Committee (FOMC) – The Federal Reserve committee is responsible for open market operations and managing the money supply in the United States.

The buying and selling of Treasury securities is called open market operations. There are 3 main reasons the Fed conducts monetary policy principally through open market operations. First, because Fed initiates open market operations, it completely controls their volume. Second, the Fed can make both large and small open market operations. Third, the Fed can implement its open market operations quickly, with no administrative delay or required changes in regulations.

2. Discount policy

3. Reserve requirements

When the Feds reduces the required reserve ratio, it converts required reserves into excess reserves. If the Feds raises the required reserve ratio, it will have the reverse effect

Security

A financial asset – such as a stock or a bond – that can be thought and sold in a financial market

Securitization

The process of transforming loans and other financial assets into securities

Investment banks differ from commercial banks in that they do not take in deposits and rarely lend directly to households. Instead they concentrate on providing advice to firms issuing stocks and bonds or considering megers with other firms.

13.5 The Quantity Theory of Money

Quantity equation

M x V = P x Y

M = Money supply

V= Velocity of money

P= Price

Y= Real output

Velocity of money

The average number of times each dollar in the money supply is used to purchase goods and services included in the GDP

Quantity theory of money

A theory about the connection between money and prices that assumes that the velocity of money is constant

Inflation rate = Growth rate of money supply – Growth rate of real output

This equation leads to the following predictions:

1. If the money supply grows at a faster rate than real GDP there will be an inflation

2. If money supply grows at a slower rate than real GDP, there will be a deflation

3. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation

Chapter 14 Monetary policy

14.1 What Is Monetary Policy

Monetary policy

The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals

There are four monetary policy goals:

• Price stavility

• High employment

• Stability of financil markets and institutions

• Economic growth

1. Price stability

Key policy goal of the Fed

2. High employment

Unemployed workers and underused factories and office buildings reduce GDP below its potential level. The goal of high employment extends beyond the Fed to other branches of the federal government.

3. Stability of financial markets and institutions

The Feds promote the stability of financial markets and institutions so that an efficient flow of funds from savers to borrowers will occur.

4. Economic growth

Policymakers aim to encourage stable economic growth because stable growth allows households and firms to plan accurately and encourages the long-run investment that is needed to sustain growth.Policy can spur economic growth by providing incentives for saving to ensure a large pool of investment funds, as well as by providing direct incentives for business investment.

14.2 The Money Market and the Fed’s Choice of Monetary Policy Targets

At times, the Fed encounters conflicts between its policy goals. So, a policy is intended to achieve one monetary goal, such as reducing inflation, may have adverse effect on another policy goal, such as raising employment.

Monetary policy target

Feds can affect targets directly and that, in turn, affect variables, such as real GDP, employment or price level. The two main monetary policy targets are the money supply and the interest rate.

Changes in variables other than the interest rate cause the demand curve to shift. The two most important variables that cause the money demand curve to shift are real GDP and the price level.

When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money.

When interest rates rise on financial assests such as U.S. Treasury bills, the amount of interest that households and firms lose by holding money increases. When interest rates fall, the amount of interest households and firms lose by holding money decreases. The interest rate is the opportunity cost of holding money.

An increase in real GDP shifts the money demand curve to the right.

A deacrease in real GDP shifts the money demand curve to the left.

An increase in the price level increases the wuantity of money demanded at each interest rate, shifting the money demand curve to the right.

A decrease in the price level shifts the money demand curve to the left.

Just as with other markets, equilibrium in the money market occurs where the money demand curve crosses the money supply curve. However, in the money market the adjustment from one equilibrium to another is a little different from the adjustment in the market for a good. When the Fed increases the money supply, the short run interest rate must fall until it reaches a level at which households and firms are willing the additional money. Rising short tern interest rates increases the opportunity cost of holding money, causing households and firms to move up the money demand curve.

Federal funds rate

The interest rate banks charge each other for overnight loans; the rate is not administrated by the Feds. The rate is determined by the supply of reserves relative ti the demand for them. The federal reserve rate is not directly relevant for households and firms. Only banks can borrow and lend in the federal funds market. The effect of a change in the federal funds rate on long term interest rates is usually smaller than it is on short run interest rates, and the effect may occur only in lag in time.

14.3 Monetary Policy and Economic Activity

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following way:

• Consumption

Lower interest rates lead to increased spending on durables because they lower the total cost of these goods to consumers by lowering the interest payments on loans

• Investment

Higher interest rates on corporate bonds or on bank loans make it more expensive for firms to borrow, so they will undertake fewer investment projects. Lower interest rates make it less expensive for firms to borrow, so they undertake more investment projects

• Net export

If interest rates in the United States rise relatively to interest rates in other countries, investing in US financial assets will become more desirable, causing foreign investors to increase their demand for dollars, which will increase the value of the dollar.

Expansionary monetary policy

The Federal Reserve’s increasing the money supply and decreasing interest rates to increase real GDP; also referred to as loose or easy policy.

FOMC orders an expansionary policy

The money supply increases and interest rates fall

Investment, consumption, and net exports all increase

The AD curve shifts to the right

Real GDP and the price level rise

Contractionary monetary policy

T

FOMC orders a contractionary policy

The money supply decreases and interest rates rise

Investment, consumption, and net export all decrease

The AD curve shifts to the left

Real GDP and the price level fall

he Federal Reserve’s adjusting the money supply to increase interest rates to reduce inflation; also referred to as tight policy.

14.4 A Closer Look at the Fed’s Setting of Monetary Policy Targets

Monetary growth rule

A plan for increasing money supply at a constant rate that does not change in response to economic conditions

Taylor rule

A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables; according to the rule, the Fed should set the target for the federal funds rate so that it is equal to the sum of the inflation rate, the equilibrium real federal funds rate, and two additional terms.

Inflation gap – Difference between current inflation and target rate

Output gap – Percentage difference between real GDP and potential real GDP

Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + ((1/2) x Inflation gap) + ((1/2) x Output gap)

Although tha Taylor rule does not account for changes in the target inflation rate or equilibrium interest rate, many economist view the rule as a convenient way to analyze the federal funds target

Inflation targeting

Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. Experience with inflation targeting has varied, but typically, the move to inflation targeting has been accompanied by lower inflation( sometimes at the cost of temporarily higher unemployment).

Chapter 15 Fiscal policy

15.1 What Is Fiscal Policy

Fiscal policy

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. Economists use the term to refer only to the actions of the federal government. The federal government makes many decisions about taxes and spending, but not all of these decisions are fiscal policy actions because they are not intended to achieve macroeconomic policy goals.

Automatic stabilizers

Government spending and taxes that automatically increase or decrease along with the business cycle

With discretionary fiscal policy, the government takes actions to change spending or taxes.

15.2 The Effects of Fiscal Policy on Real GDP and the Price Level

Expansionary fiscal policy

Increasing government purchases or decreasing taxes. An increase in government purchases will increase aggregate deman d directly because because government expenditures are a component of aggregate demand. A cut in taxes has an indirect effect on aggregate demand.

Remember that the goal of both expansionary monetary and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy.

Contractionary fiscal policy

Decreasing government purchases or increasing taxes; policymakers use it to reduce increases in aggregate demand that seem likely to lead to inflation.

15.3 The Limits of Using Fiscal Policy to Stabilize the Economy

Poorly timed fiscal policy can do more harm than good. Getting the timing right with fiscal policy can be difficult because obtaining approval from Congress for a new fiscal policy can be a very long process and because it can take months for an increase in authorized spending to actually take place. Because an increase in government purchases may lead to a higher interest rate, it may result in a decline in consumption, investments and net exports.

Crowding out

A decline in private expenditures as a result of an increase in government purchases

Ost economists agree that in the short run, an increase in government spending results in partial, but not complete, crowding out. What is the long run effect of a permanent increase in the govenment spending? In this case, most economists agree that the result is complete crowding out.

Chapter 17 Macroeconomics in an Open Economy

17.1 The Balance of Payments: Linking the United States to the International Economy

Open economy

An economy that has interactions in trade or finance with other countries. Open economies interact by trading goods and services and by making investments in each other’s economies.

Closed economy

An economy that has not interactions in trade or finance with other countries. Noeconomy today is completely closed, although a few countries have limited interactions with other countries.

Balance of payments

The record of a country’s trade with other countries in goods, services, and assets; the record contains three ‘accounts’: Current account, financial account and the capital account

1. The current account

The part of the balance of payments that records a country’s net exports, net income on investments (Difference between investment and investment income paid), and net transfers (Difference between transfers made to residents of other countries and transfers received by US residents from other countries)

• Balance of trade

The difference between the value of the goods of a country exports and the value of the goods a country imports; balance of trade is the largest item in the current account. If country exports more than it imports, it has a trade surplus. If its exports less than its imports, it has a trade deficit.

Net export equals the sum of the balance of trade and the balance of services (Difference between the value of the services a country exports and the value of the services a country imports).

Note that, techniclly, net exports is not equal to the current account balance because the current acount balance also includes net income on investements and net transfers. But these 2 items are relatively small.

2. The financial account

The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country; it records long-term flows of funds into and out of a country. Another way of thinking of the valance on the financial account is as a measure of net capital flow (Difference between capital inflows and capital outflows).

When firms build or buy facilities in foreign countries, they are engaging in foreign direct investment. When investors buy stock or bonds issued in another country, they are engaging in foreign portfolio investment.

• Net foreign investment

The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment (When firms build or buy facilities in foreign countries) plus net foreign portfolio investment (When investors buy stock or bonds issued in another country).

3. The capital account

The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets, such as copyright, patent or trademark.

The sum of the current account balance, the financial account balance, and the capital account balance equals the balance of payments, which is always zero. If the sum of the current account balance and the financial account balance does not equal zero, some imports or exports of goods and services or some capital outflows or inflows were not measured accurately.

17.2 The Foreign Exchange Market and Exchange Rates

Nominal exchange rate

The value of one country’s currency in terms of another country’s currency

Real exchange rate

Corrects the nominal exchange rate for changes in prices of goods and services.

The market exchange rate is determined by the interaction of demand and supply, just as other prices are. There are three sources of foreign currency demand for a country’s currency:

4. Foreign firms and households that want to buy goods and services produced in the country

5. Foreign firms and households that want to invest in the country either through foreign direct investment or through portfolio investment

6. Currency traders who believe that the value of the country’s currency in the future will be greater than its value today

Equilibrium in the market for foreign exchange occurs when the quantity supplied equals the quantity demanded. Surpluses and shortages are eliminated very quickly because the volume of trading in major currencies such as the dollar and the yen is very large, and currency traders are linked together by computer.

Currency appreciation

An increase in the market value of one currency relative to another currency

Currency depreciation

A decrease in the market value of one currency relative to another currency

There are three main factors causing the demand and supply curves in the foreign exchange market to shift:

7. Changes in demand for domestic produced goods and services and changes in the demand for foreign-produced goods and services

8. Changes in the desire to invest in the domestic country and changes in the desire to invest in foreign countries

9. Changes in expectations of currency traders about the likely future value of the domestic currency and the likely future value of foreign currencies

Speculators

Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates

Some currencies, however, have fixed exchange rates that do not change over long periods. In this occasion, the country’s cenral bank has to intervene in the foreignn exchange market to buy and sell its currency to keep the exchange rate fixed.

A depreciation in the domestic currency will increase exports and decrease imports, thereby increasing net exports. An appreciation in the domestic currency should have the opposite effect: Exports should fall, and imports should rise, which will reduce net exports, aggregate demand, and real GDP.

Real exchange rate

The price of domestic goods in terms of foreign goods

Real exchange rate = Nominal exchange rate x (Domestic price level/Foreign price level)

Real exchange rates are reported as index numbers with one year chosen as the base year. As with the consumer price index, the main value of the real exchange rate is in tracking changes over time – in this case, changes in the relative prices of domestic goods and in terms of foreign goods.

17.3 Monetary Policy and Fiscal Policy in an Open economy

The economists refer to the ways in which monetary and fiscla policy affect the domestic economy as policy chennels. An open economy has more policy channels than does a closed economy.

In an open economy, a conractionary fiscal policy will have a smaller impact on aggregate demand and therefore will be less effective in slowing down an economy.

Chapter 18 The International Financial System

18.1 Exchange Rate Systems

Floating currency

The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply; some countries attempt to keep the exchange rate constant, such as China.

Exchange rate system

An agreement among other countries about how exchange rates should be determined

Manages float exchange rate system

The current exchange rate system, under which the value of most currencies is determined by demand and supply, with occasional government intervention

Fixed exchange rate system

A system under which countries agree to keep the exchange rates among their currency fixed. Gold standard and Bretton Woods system are both fixed exchange rate systems

18.2 The Current Exchange Rate System

There are three important aspects that control the current exchange rate system:

1. The United States allows the dollar to float against other major currencies

2. Most countries in western Europe have adopted a single currency, the euro

3. Some developing countries have attempted to keep their currencies’ exchange rates fixed against the dollar or another major currency

Theory of purchasing power parity

The theory that in the long run, exchange rates move to equalize the purchasing powers of different currencies. Once the exchange rate reflected the purchasing power of the two currencies, there would be no further no further opportunities for profit. This mechanism appears to guarantee that exchange ratese will be at the levels determined by the purchasing power parity.; three real-world complications, keep purchasing power parity from being a complete explanation of exchange rates:

1. Not all products can be traded internationally

2. Products and consumer preferences are different across countries

We expect the same product to sell for the same price around the world, but if a product is similar but not identical to another product, their prices might be different. Prices can also differ across countries if consumer preferences differ

3. Countries impose barriers to trade

Tariff – A tax imposed by a government on imports

Quota – A government –imposed limit on the quantity of a good that can be imported

The four determinants of exchange rates in the long run

1. Relative price levels

If prices of goods and services rise faster in the domestic country than in another country, the value of the domestic currency has to decline to maintain demand for domestic products

2. Relative rates of productivity growth

When the productivity of a firm increases, the firm is able to produce more goods and services using fewer workers, machines and other inputs. The firm’s cost of production falls, and usually so do the prices of its products.

3. Preferences for domestic and foreign goods

If consumers in Canada increase their preferences for US products, the demand for US dollars will increase relative to the demand for Canadian dollars, and the US dollar will increase in value relative to the Canadian dollar.

4. Tariffs and quotas

Quota increases the demand for the domestic currency relative to the currencies of foreign countries

Having a fixed exchange rate can provide important advantages for a country that has extensive trade with another country. When the exchange rate is fixed, business planning becomes much easier.

Pegging

The decision by a country to keep the exchange rate fixed between its currency and another currency. A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued.

However, the overall trend has been to toward replacing pegged exchange rates with managed floating exchange rates.